Cap Rates: Ultimate Real Estate Investing Guide

By Adam Gower Ph.D.

I'll tell you right now this is probably one of the most used terms in real estate and it is one of the most misunderstood. As much as it’s used, it always astonishes me how little cap rates are understood. If you ask 10 brokers, " what is a cap rate?" they might give you a basic idea of what it is. But if you ask them to explain exactly how it is calculated and what goes into the calculation, you'll get a lot of different responses.

It's consistent throughout real estate that the terms used have a general understanding in the market, but are in many cases understood differently by different people. There's no centralized School of Real Estate. There may be actual definitions somewhere that are definitive of a concept but there's no requirement for everybody to read and learn those concepts or those definitions.

 

Consequently, people understand most concepts in real estate through the lens of their own personal experience and who it was that taught them or how they came to learn what the concept meant.

Buildings Looking Down adjusted

So there's very little consistency and I would encourage you that any time you see a concept being used by a sponsor and you're not really sure exactly what it means, don't hesitate to ask what he or she means by the idea. In some cases, you might find the answer to be enlightening.

Background Information on Cap Rates

One of the interesting aspects of having that understanding of the concept is that if somebody doesn't really understand what a cap rate means, it can lead to errors.

"Errors can be exploited. You might find a sponsor discovered a deal where a seller described a cap rate inaccurately and used the cap rate that the seller believed was consistent with the market."

So, sold a property at a certain cap rate and sold it for a certain price based on the ratio that is the cap rate, assuming that the cap rate was market. If they made a mistake, they may have underpriced the asset.

The buyer, the sponsor you're investing in, may have found a bargain because the seller miscalculated the cap rate or anything else for that matter. And as a consequence, it is able to unlock found value that the seller didn't know exists because the seller didn't really understand the concept of how to price the property properly.

What is a Cap Rate?

I find the best way to think about what is a cap rate is to think of it like interest earned in the bank. So if you put $100 into your account at the bank and the bank pays you 1% per year interest, then you're going to receive $1 at the end of the year. This is the same as the concept of capitalizing on your money, making the most out of it by putting it in the bank, and earning $1 a year for that $100 that you've put there.

Detroit Skyline

How to Capitalize on Your Money

In this case that I give you here, the bank is offering you 1% for your $100. They're giving you $1 for $100 deposited. You can think of cap rates like the interest earned on your money, just with some nuances. It's not the same as the return that you're getting on your investment. The cap rate pertains to something different, but it's like the interest rate on money.

One of the primary uses of a cap rate is because it is an equalizer, it is a metric that is used across every type of real estate investment. It is something that you can use, provided it is used consistently across all deals that you look at, to compare them against each other for the kinds of returns that they're going to be offering you. It will help you to be able to compare deals against each other to decide what to invest in and what not to invest in.

Because it's used by every type of asset, it also means that you can compare the kinds of returns that you're going to get. For example, in an apartment deal versus in a hotel deal versus in a senior housing deal versus in a warehouse deal.

It's not the absolute defining difference between all types of development, but it's a very important component to making a comparison.

money in wallet

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How Does a Cap Rate Work?

What does that mean to price? There's an inverse relationship. The lower the cap rate, the higher the price.

Let's go back to our banking example.  And let's say that we're going to deposit $100 and get 1%. If you want to earn $1, you have to spend $100 on a deal. This would be the same as a 1 cap investment.

Let's say it goes to a 5 cap.  The bank is now offering you a 5% interest. You will have to put $20 into the bank to be able to get a $1 income at 5%. So if you think about that from a business perspective or from a real estate perspective, what that means is that if the cap rate is higher, the price of the property is lower.

"So let's say you want $1 million of income a year and it’s a 5 cap market. You would need to spend $20 million to have that $1 million."

The idea is that if the market were a 1 cap, a much lower cap rate, in order to earn that million dollars that you want a year, you would have to spend $100 million.

So the implication for you as a crowdfund real estate investor is that you can spread your investments across multiple asset classes in order to blend returns and mitigate risk. So you can choose to invest in higher cap rate asset classes and locations or lower cap rate asset classes and locations. It's a tool that you can use to balance your portfolio.

You might see buildings in one market that are in the mid-millions. So picking apartments, for example, is an easy one to look at. You might see apartments in the mid-millions, so how do you compare those two? Is one arbitrarily 5 times as much? What you're likely to find is that the rents are higher and the only way to really measure it is through the relationship between incomes, what people spend on housing, and the cost of buying into those markets.

One way to look at is the cap rate. That's going to equalize and allow you to compare different markets. Using cap rates also affords you the opportunity to employ investment strategies that contrast buying low cap rate assets in high cap rate markets versus buying high cap rate assets in low cap rate markets. Or another way of saying that in plain-ish English is buying expensive properties in cheaper areas.

Expensive Property vs Cheap Property

Which is better: buying an expensive property in a cheap area or a cheap property in an expensive area? Well, it just so happens that I had a very interesting conversation with Dr. Greg McKinnon of the Pension Real Estate Association (PREA).

 

He's an academic and economist at the association and he conducted some very detailed research over an extended period of time. He examined whether or not it's better to invest in high cap versus low cap areas and low cap buildings versus high cap.

What he concluded was that it is better to invest in higher return properties in less expensive areas than it is to invest in lower return properties in more expensive areas.

If you want to listen to what he has to say about that, go to the NREforum.org/valueinvesting. I explained in great detail what he discovered and you can also download the paper that he wrote If you really want to get into the DNA.

The cap rate really is a simple concept but it is often misunderstood, as I mentioned. I'm going to walk you through some different perspectives so that you can have a deeper understanding of what it means by approaching it from different angles.

For more information and to gain access to:

  1. Guided tour of 8 real estate crowdfunding websites
  2. FREE: Complete list of every real estate syndication website
  3. FREE: 10 things to look for in real estate contracts
  4. Access to advanced real estate investment training

Cap Rates and Debt

There is one fundamentally important rule when it comes to cap rates: the cap rate only refers to unlevered numbers. That means that you cannot include debt in a cap rate calculation. So when you look at a 10 million dollar building and it's throwing off a half million in income every year, it's giving 5% interest. But you cannot look at the return on equity.

The only way to measure the cap rate is to measure it against the unlevered cost of the building. Whether it's the cost of building it or the cost of buying it against the projected net operating income or the actual net operating income, there’s no debt allowed in your cap rate calculation.

By using the “assuming all cash” approach and eliminating debt from the concept of the cap rate, it allows you to really compare apples to apples.

What is a Good NOI for an Investment Property?

Another way you can think of the cap rate is as inferring a multiple of NOI. For example, there's a building on the market with an NOI of $50,000 and you buy it for $1 million. What you did was paid 20 times the net operating income for that building. What it means is that for every dollar of net operating income that you add, you increase the building value by 20 times that increase in NOI, right?

Here's another example. Let's say you got a 10 unit apartment building and each unit pays $1,000 a month in rent. That's $120,000 of gross income.

And so you take the gross income and you deduct costs, let's assume 30% of costs. So your NOI, your net operating income, is that $120,000 - $36,000. So your net operating income is $84,000.

"The sponsor now increases the rents by $100 per unit. Assume that this extra money drops straight to the bottom line, meaning that is there are no additional costs associated with the price increase."

Now your NOI, or net operating income, went up by $100 a month times 10 units times 12 months. Your NOI went up by $12,000. So what does that mean in terms of the value of the property? The value of the property just went from $1.68 million to $1.92 million. The value went up nearly a quarter of a million dollars just because the sponsor increased the rents by $100 per unit.

That's a heck of a way of seeing the added value. And a lot of the deals that you see on crowdfunding sites are using the same kind of idea to add value.

Ways to Increase the NOI

What are the ways that a sponsor can increase rents? One idea would be to ask nicely. You never know. A more likely method would be to improve the units. You could evict tenants as well depending on morals, ethics, and if the law allows. It's just business in many cases.

Other options would be to install recessed lights, put more lighting into a unit, brighten up the lobby area to give it a higher sense of luxury or appeal, and improve the landscaping area. On a lot of crowdfunded sites, these are the kinds of deals that you're going to see.

Assuming that all that work costs the sponsor $10,000 a unit, or a total of $100,000, and the building goes up in value $240,000, maybe it's worth it to increase rents.

apartment buildings

"Build to" Cap Rates

Build to cap rates is a concept that's just a bit more advanced. The build to cap rate example can be used to determine if a deal is a go or no-go. You have a sponsor who wants to buy a piece of land for $3 million and he wants to build apartments on it. It's going to cost him $70 million. The total cost of the project that he is contemplating is going to be $20 million.

In scenario 1, once he's completed and stabilized the building, he's going to have a building that is giving off $100 million of NOI. That means that if the market in that area was a 5 cap,, then the value of his building would be 20 million with a 1 million dollar NOI.

Obviously, you don't want to build and not make any money, as this scenario would deliver. The sponsor, in this case, is building to a 5 cap. And there's no point building to a 5 cap if the market rate for properties in that area is also a 5 cap. If you use a build to cap rate, there's no upside. You're not going to make any money. It's not worth it.

Changing the NOI stabilization to $1.4 million, the sponsor is building to a 7 cap. The cap rates are calculated as 1.4 million divided by the cost of construction equals 7%, right? If the market in this area is willing to pay a 5 cap, then the value of the building when he completes it is going to be 1.4 million divided by 5 times 100. So 28 million. He built to a 7 cap but the market is a 5 cap and therefore the value is 28 million. So this could be a “go” scenario. The two percent difference between the build to cap and the market cap makes this deal look like a “go” deal.

Cap Rate Terms You Need to Know

I’m going to tell you a few more terms that you might hear in the field from sponsors talking or the kinds of words that they may use.

Continuing with the same example, the sponsor has built to a 7 cap in a 5 cap market. What we now have is a 200 basis point spread. You might hear someone say, “I'll never do a deal without a 200 basis point spread between market and ‘build to’”. Or they might say “200 bips”, “200 BPS”, or “2% spread between the cost and the market value.” If it has a 200 bip spread between market value and his build to rate, those are deals that he'll start to drill down on.

To present this in a slightly different perspective, it's the same as saying that somebody is looking in the market to earn 5% on their money, and the sponsor is offering $1.4 million. This means that they are going to be prepared to pay $28 million in order to buy that income stream of $1.4 million. So the sponsor’s cost, in this case, is $20 million. The buyer is willing to buy the net operating income stream for $28 million, so the deals are good. This is a quick way for sponsors to screen deals.

For more information and to gain access to:

  1. Guided tour of 8 real estate crowdfunding websites
  2. FREE: Complete list of every real estate syndication website
  3. FREE: 10 things to look for in real estate contracts
  4. Access to advanced real estate investment training

Variations of Cap Rates

There are a few variations in cap rates. You’ll find that apartments are often the highest demand asset class and consequently, they have the lowest cap rate. If you're into apartments, you're probably going to be paying more for the income stream that comes off an apartment than you are likely to be paying for any other asset class out there. It's generally seen to be the most secure asset class during a downturn.

However, that doesn't mean that you can't overpay for apartments. The reason it is a secure asset class is that it does have an income stream. And so to contrast that with an extreme example, it's the exact opposite of land. You might invest in land and get a great deal on the land. But when the market turns hey, guess what?

 

"There's no income from land."

 

In fact, that’s the only expense. You've got to pay insurance and property taxes. So land is gonna suck money out of you during a downturn whereas apartments will be filled with tenants. Even if the tenants are paying less rent, there's still income coming off of the property. Apartments are seen as being highly desirable because they are income producing properties.

Again, though, you can lose money in real estate. When I say it's a secure asset class, take that with a grain of salt. It's all relative.

 

One issue that you do see with apartments is that there is typically a lot of overbuilding, especially in the luxury end of the market. As land prices go up, sponsors have to buy land at higher prices. So the only way they can justify the underwriting is by increasing their projected rents at the other end. And so the only way they can do that is by building ever increasingly luxurious apartment buildings.

So, what'd you find is that there ends up being a glut at the high end of the apartment market during the end of a cycle, the end of the upswing of a cycle, and a lack of product at the more affordable end of the market. For whatever reason, it still remains a very popular asset class and always has been.

traffic-from-above

Yesterday vs Today vs the Future

There is a tendency in the industry to make a distinction between cap rates of yesterday versus today versus how they are going to be. Let me unpack that a little bit for you. So listing brochures that advertise apartment buildings will often talk about the distinction between the current cap rate for the building and the market cap.

It may say that building is being sold at a 5 cap but on current income, the market rates are higher. Consequently, you're actually buying it for a 6 cap. So you’re getting a steal. So if it's a 5 cap market and you're paying a 6 cap price, you're getting a bargain.

Sponsors, similarly, may characterize returns based on projections and not actual income. This idea is sometimes referred to as trailing versus forward-looking cap rates analysis and there's a significant difference. What is this building currently earning? What has it earned historically versus what are you projecting? This is one of the keys to the due diligence process.

The sponsor is going to be projecting some kind of return, no guarantees. They're going to be projecting what they think they can get and that's why you have to be so careful. The only thing you know for sure is what has happened and how the building performed historically. You don't know how it's going to perform in the future.

"The sponsor is explaining to you their thesis for where they think the value is going to go but they just don't know for sure. You may see sponsors who are confident that they have uncovered a building that has untapped value in it somehow."

This could be that maybe the rents are low, it has been owned for decades by the same family, or the Heirs let it run down a little bit, but it's in a high rental area. In other words, they're paying very high prices relative to the kind of cap rates that that particular market is commanding because they're projecting the future cap rates will be significantly higher.

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